For monitoring market risk, the company will need to segment the overall investment portfolio. They may for instance segment the portfolio by product, then trading desk, then trades. For each segment of the portfolio limits will be defined. Generally, limits increase as you move up in the hierarchy. For example market risk hierarchy may be established as depicted below. A risk metric is selected (duration, VaR, etc) and risk limits are specified for each component of the hierarchy based on this metric.
When the stop loss limit is breached the investment will be liquidated as soon as possible. Any exception to this process should be approved at the right authority level within the risk management division. This exception approval hierarchy will generally be based on absolute dollar/dirham amount of loss that can be booked on a position before it should be cut, and will be suggested by the risk management group and approved by the Board Risk Committee.
For instruments that trade and are re-priced on a daily basis we need to consider the interaction of credit risk (a counterparty default) and price risk (the risk that the market has moved against us).
What happens when a counter party defaults on settlement when
He has to deliver a bond that you have purchased and
- bond prices have moved downwards
bond prices have moved upwards
He has to take delivery of a bond that you have sold and
- bond prices have moved downwards
- bond prices have moved upwards
- Do we have the same exposure on a derivative contract? Interest Rate Swaps and Cross Currency Swaps
He has to deliver Euros that we have purchased and
- US$/Euro Exchange rate has appreciated in favor of Euro
- US$/Euro Exchange rate has appreciated in favor of US$
Do we have the same exposure on option contract?
- How do we calculate Potential Future Exposure?
Counterparty Limits – Measuring Exposure
Counterparty limit setting process can be broken down into two categories.
The first is the Financial Institution (FI) limit setting process which is dealt with through the FI function.
The second is a customer limit which is treated and calculated in the same manner as allocation of credit to corporate customers.
The FI limit setting process entails setting limits depending on:
- Issuer’s credit rating (limits set on issuer based on credit rating)
- Analysis of its financial health and strength, including capital adequacy, asset quality, earnings/ profitability, liquidity position, cash flow generation capacity, liquidity, ratios (limits set based on acceptable levels for financial ratios).
- Institution profiles, such as the history, nature of business, types of business, product offerings, branch network and compliance with KYC (limits set based on acceptable benchmarks for each characteristic)
The FI limit setting process may also be product specific.
For a corporate customer, especially on derivative contracts, the primary question on a given transaction is Potential Future Exposure. How much money can the bank lose if the customer defaults on settlement? And is there anything the bank can do to secure that exposure?
Besides stop loss limits discussed above the following limits should also be set:
Inventory age limits
Inventory age limits set the time for which any security is held without being sold. This is to prevent traders from sitting on illiquid positions or positions with an unrecognized loss. The time allowed will depend on the overall purpose of the desk. If the desk is expected to trade in and out of the position quickly, the limits will be on the order of days. If the desk is expected to use long-term strategies then the limit can be on the order of weeks or months.
Concentration limits prevent traders from putting all the eggs in one basket. They ensure that the traders risk is not concentrated in one instrument or market. For example the equity desk may be limited to a maximum of 3% in any one company. This may also be subject to a limit on total percentage of that company’s equity that may be held.
Capital Loss & Stop loss limits
Stop loss limits act as a safety valve in case something starts to go wrong. Stop loss limits state that specified action must take place if the loss exceeds a threshold amount. Tight stop loss limits reduce the maximum possible loss and therefore reduce the capital required for the business. However, if the limits are too tight they reduce the trader’s ability to make a profit.
The first step in setting stop loss limits is to determine the appetite of the company regarding its risk tolerance. This translates to specifying the amount of capital that the company can afford to lose.
The following elements would need to be considered when determining the capital loss amount.
- The expected rate of return that will be earned on the capital will the next twelve month period.
- The rate of return that will be required to satisfy shareholders.
Here what we covered on Saturday at the Treasury Risk crash course at the Karachi Marriot (thank you Agnes for the notes). The one day Treasury Risk workshop in Dubai is now locked in on the 18th of March 2010 at the Dusit Thani in Dubai. You can download the nomination form here for the workshop.
First, to view trends from a much broader perspective, in general the practical as opposed to the quant/ data way to view distributions (effectiveness, behaviour, relationships). This is be one with the generator function (Nassim Taleb and Fooled by Randomness) or what we call the Nirvana effect.
Second, what is really happening when model price match market prices, especially in illiquid markets such as the one year FX swap space here in Karachi, Pakistan.
Third the difference between economic capital, regulatory capital and loss capital.
Fourth, linking Value at Risk limits to Stop loss limits and linking stop loss limits to book size and risk appetite.
Fourth, the second definition of Convexity, the fact that asset prices tend to rise by more and fall by less when interest rates change and the criteria for asset liability management and hence asset selection based on convexity (convexity of assets > convexity of liabilities).
Fifth, the allocation of portfolio assets by ALM criteria (duration and convexity)
Sixth, normally distributed actual returns are a reflection that a risk manager has not added value (similar to a coin toss) and that skewness is something to be viewed favorably, provided that it is skewed in the direction that meets existing risk return philosophy.